Unit 2 Macro: The UK Economy - What Would Keynes Do?

 I set some of my AS economics students an assignment on Keynes last week. The starting point was the first of Stephanie Flanders' excellent series featuring Keynes, Hayek and Marx. We watched it in class and I was keen for students to explore some of the guiding principles of Keynesian economics well before we get stuck into AD-AS analysis. I am also desperate to avoid showing them a mark scheme until March at least (when I am taking a sabbatical!) - so I marked their work mainly on the quality of their writing and whether or not I enjoyed reading it! I have showcased a few examples below of their answers.
 Assignment:
 The UK economy is struggling to recover from the last recession. Private sector demand in the form of consumer spending and business capital investment remains weak, confidence is low and exports of goods and services have been affected by problems in the economies of many of our trading partners. UK GDP remains well below the peak achieved before the start of the last recession and unemployment continues to rise. Keynesian economics has made a comeback in recent times, indeed many governments around the world have decided to introduce Keynesian policies as a way of injecting fresh demand into their fragile economies.
 Analyse how the macroeconomic problems outlined above would be approached by Keynesian economists. In your answer try to capture the essence of the Keynesian approach and attempt to raise and discuss some of the criticisms that have been levelled at Keynes.

Kelvin Anim

At the heart of Keynesian economics is the belief that government is in a unique position to be able to catalyze growth in an economy. With the funds and authority available to it, government is able to, through tax cuts; interest rate cuts and the expansion of public projects, grow the economy. These factors work together in maximizing public confidence in the markets, thereby leading to the public spending more on goods and services. Keynesian economics is therefore the use of government stimulus in order to alter the behavior of consumers to trust in the markets.

First, Keynesian economics states that, a reduction in interest rates will eventually lead to increased spending and hence grow the economy. The first step is that central banks, such as the Bank of England, lend money to Commercial banks at a low interest rate. This sends a signal to commercial banks to lower their interest rates. This means for the average person that if they borrow money from a bank the amount on top of that, that they have to pay, is significantly lower than it would have been. This means that the public is more likely to borrow and therefore spend their money on goods and services; this injects money back into the economy as demand for goods increase. More specifically, small domestic firms can borrow at a low interest rate and therefore have the ability to hire more staff members, which increases employment levels. These firms now also have the confidence to purchase more capital, increasing output, which satisfies the now increased demand. With factor incomes increasing the quality of goods produces, in theory, can also increase. Consumption alongside demand increases, as consumers get more confident.

Second, it is the belief of Keynesian economists that, substantial increases in investment, by the government, in public projects or infrastructure will result in growth of an economy. If the government were to invest a million pounds in the building of a leisure park in a London suburb, the investment would create new business opportunity for businesses that want to occupy the spaces in the leisure park. Employment would increase, as builders would be needed to build the park and staff members would be needed after the completion of the leisure park. This essentially, creates income for households. What does this eventually mean? This means increased demand for goods as more people now have the money to be able to purchase goods. Furthermore, the interest rates set on the loans the companies occupying the leisure park space took out would be low. This means it’d be cheaper for these businesses to rent out a space in the parking lot. Hence, they will have more money to spend on the production of their goods and on capital leading to more good being produced to satisfy the increase in demand.

Thirdly, the cutting of taxes is an important belief in Keynesian economics in order to increase demand for good. This is especially true for people of the lowest income in society. How does this work? Tax essentially makes goods more expensive. So it follows that cutting tax on goods and services means that they will become cheaper. Because people want goods for as low a price as they can get in order to be able to buy other goods they will demand more of a good if it costs less for them to buy it with their disposable income. This results in firms producing more goods to satisfy this increase in demand. So factor income increases, meaning the workers in these firms have increased disposable income to buy other goods in the economy and so on. Essentially, consumer confidence has increased as they are getting more for their money.

It was Keynes’ belief that excessive saving deprived an economy of growth. Basically, money saved equals money not being put back into an economy. This stifles growth because producers of goods have less people buying their goods so their revenue decrease. Hence, they haven’t got as much revenue to spend on the production of more goods. In order to cut back, they have to sack employees to make up for the loss of revenue and profits.

Criticisms leveled at Keynes includes the argument by economist Friedrich Hayek that short term governmental fixes eventually lead to large scale governmental programs which have a monopoly on infrastructure stifling the private sector. Meanwhile, whilst the government is over spending, it is building a very large budget deficit. Furthermore, because employment is so high it has to pay the wages of the new employees and fund many infrastructure programs. Hence it can be argued that revenue for the government in this instance is substantially decreased.

In summary, Keynes believes that the best way to grow an economy was to instill confidence in the consumer; this would lead to more demand and more being produced. However, the question still stands, is government the best body to ascertain the confidence of consumers and would this lead to too much reliance government?

Dan Thomson

In essence, the Keynesian point of view is two fold, and springs from the idea that Market Economies are not self-stabilizing. Firstly, you can borrow to spend your way out of a recession, it is the encouragement of “animal spirits” that is vital for the growth of the economy, the psychology of the market is as important as the numbers. This way of thinking is opposed by Prime Minister David Cameron who takes the view in a “debt” crisis, debt must be dealt with. A Keynesian economist might argue instead that austerity will lead to an increase in unemployment, making more people reliant on welfare. This forces the government to spend more on welfare, while people have less expendable income to spend on consumer goods. This results in low “animal spirits”, leading to low investment, even less growth, and the possibility of even more debt.

Secondly through the interconnectedness of the post-Globalization world, Keynes would advocate that one can not “beggar thy neighbor,” the prosperity of every nation is important to the prosperity of the individual nation or economy.

Thus, in the situation described above, a Keynesian approach in the face of; “Private sector demand in the form of consumer spending and business capital investment remaining weak, confidence being low and exports of goods and services having been affected by problems in the economies of many of our trading partners,” would be to increase public sector spending. An increase in borrowing would be a large aspect of financing this. The logic behind doing so is that the borrowing if used correctly will pay for itself.

In a recession, increased taxation on the very rich can be justified, and would also help raise the government’s public spending budget. At the same time a slight tax break on lower income households wouldn’t affect the government’s ability to spend on the public sector to a very significant level, especially in the context of higher taxes on the very rich. The reason behind cutting taxes on the poor, as illustrated by the Australian Government is that it allows more lower-income households to spend more money on necessity goods, creating a rise in GDP. This is due to a low marginal propensity for those of lower incomes to save.

This public spending could go towards financing big infrastructural projects, and prudent investments that would have gotten financing in good economic times. The hope is that these investments will see profit in the future; while in the present time it immediately creates jobs, and encourages the growth of businesses. This would result in increased consumer spending, coupled with lower unemployment to result in the raising of “animal spirits”.

This rise in animal spirits would signify to investors the advent of a more confident market, thus the hope is that private investment would rise, and more projects would get off the ground without the help of government funding. This rising cycle of profit and investment is what Keynesian Economists would call, “the Multiplier Effect.”

(There are some criticisms of this approach; Paul Ormerod suggests that the Multiplier Effect may not be big enough to cover the cost of the investment. Keynes argued that the multiplier was between 2 and 3. However Ormerod points to his own research which suggests it being somewhere in the range of 0.5 and 1.2, and Nobel Prize winner Robert Barrow argues for it being 0.6. There is thus a strong argument against increasing public spending to spend one’s way out of a recession, as it can take you further into debt if the multiplier isn’t big enough. )

While this is happening, to quicken and facilitate recovery, a Keynesian economist would suggest cutting interest rates and VAT. This would encourage investment and importantly, consumer spending, this is vital in supporting the new investments that have been made in the private sector, demand for the goods being produced needs to be created by encouraging spending. This leads to a decrease in leakages in the economy and an increase in injections.

As a result of the increased profits that companies would see, they would be able to hire more staff, further decreasing the unemployment level.

From a long term perspective at this point the government must take measures to ensure that another such crisis never occurs. Stability in the global market is vital, and a country such as the UK can help do this by not “beggaring thy neighbour.” Thus, imports from the weaker economies must be encouraged by those states that can afford a trade deficit. Lowering tariffs on these imports should also be encouraged. Countries such as Germany, if following a purely Keynesian viewpoint would follow suit by not imposing such tough austerity measures on Greece. As Keynes would have seen at Versailles, this approach of “beggar they neighbour” certainly did not end well for anyone.

The encouragement of growth in third world countries should also be a major policy in international organizations such as IMF, UN and the World Bank. From an ideological point of view, decisions should be taken not solely with the interests of the UK in mind, but in the wider context of a globalized economy.

Masters of Money - Keynesian Economics

Mervyn King on Keynes